Mezzanine Loans in Plain English
Mezzanine loans are similar to second mortgages, except a mezzanine loan is secured by the stock of the corporation that owns the property, as opposed to the real estate. If the lender forecloses on the stock, it owns the corporation that owns the building. Why use a mezzanine loan? Why not just use a garden-variety second mortgage? The answer is that a lender can foreclose on a mezzanine loan in just 5 weeks, as opposed to 18 months. We’ll cover this in more detail further below.
For ease of understanding, I am going to use the words, “corporations” and “stock”, throughout this training article. In real life, title to most large commercial properties these days is held in the name of a limited liability company (“LLC”). LLC’s do not have stock. They have membership interests instead. For our purposes, however, there is little difference between a corporation and a LLC, and "corporations" and "stock" are easier terms for most people to understand.
You will never find a mezzanine loan in a first mortgage position. Since mezzanine loans can be foreclosed in just 5 weeks, no owner of a $50 million office tower is going to put himself in a position where his building could be repossessed while he is on a three-week camping trip with his family. "Hey boss, while you were away, Linda forgot to make the mezzanine loan payment. Last Wednesday the mezzanine lender executed on the building, and you were completely wiped out." Yikes! By the way, a lender forecloses on a mortgage and executes on personal property collateral (cars, equipment, coin collections, etc.). Therefore there will always be a big first mortgage in front of a mezzanine loan. In the capital stack, the pecking order of priorities would be the first mortgage, followed by the mezzanine loan, followed by owner’s equity in the property.
Why can a mezzanine lender foreclose (more precisely execute) on the stock of the corporation in a matter of just a few weeks, as opposed to a great many months? This is an extremely important issue because it can take 18 months to two years to foreclose a mortgage in many states.
Stock is personal property, like a car, a stamp collection, or a valuable painting. It's not real estate. Real estate is land and that which is affixed to the land. Personal property is everything else, which definition includes stock. Personal property can be seized immediately upon default, and it can be sold off in any manner that is commercially reasonable.
What happens when you miss the payments on your car? Does the lender have to go through an 18-month long foreclosure process? Heck, no! If you fall behind in your car payments, you might come out of a McDonald’s one day to find your car hooked up to a tow truck that is already a half-mile away. I actually “popped” a couple of cars in my first job after college. It was pretty exciting work because the debtor often chases after your tow truck threatening murder. Fortunately I never got shot. Ha-ha!
Why is a fast foreclosure process so important to a junior lienholder? My own hard money commercial mortgage company once had to foreclose on a mortgage in New York, and it took almost two years. Yikes! In contrast, a mezzanine loan is secured by the stock of a corporation, which is personal property and can be seized much, much faster.
Let’s suppose you make a $5 million second mortgage behind a $12 million first mortgage. At 6% interest, the monthly payments on a $12 million first mortgage are around $80,000 per month. In New York, 18-month foreclosures are commonplace. As the junior lien holder, you simply must keep the first mortgage current; otherwise, the first mortgage will foreclose and wipe you out. Can you imagine having to advance $1.5 million to the first mortgage holder while you take 18-months to foreclose your second mortgage? Arghh.
But if you made your $5 million loan as a mezzanine loan, rather than as a second mortgage, you could complete your foreclosure in just five weeks. Instead of “popping” a car, you will have “popped” a huge office tower. Remember, once a mezzanine lender owns all of the stock of the corporation that owns the property, the lender now owns the property.
Mezzanine loans are typically very large loans. The average size of a mezzanine loan is probably around $10 million, and most mezzanine lenders have a minimum loan size of $5 million. It is hard to find a mezzanine lender who will slug through all of the required paperwork for a mezzanine loan of less than $3 million. It is occasionally possible to obtain a mezzanine loan as small as $2 million from a hard money lender; but these tiny mezzanine can be pretty expensive.
Mezzanine lenders want big projects. When you think of a mezzanine loan, you should think of a very tall office tower or a huge power center - big properties. If the property that you are trying to finance is not worth at least $15 million, you may have a hard time attracting the interest of very many mezzanine lenders.
There are three typical uses for a mezzanine loan. The first is to pull equity out of a building that has appreciated in value. Suppose the owner of a $20 million shopping center has a $10 million first mortgage from a bank. The owner wants to pull out some equity, but he cannot simply refinance the shopping center because the first mortgage has either a lock-out clause or a huge defeasance prepayment penalty. In this instance, he might be able to obtain a $5 million mezzanine loan to free up some cash.
Here’s a second use for a mezzanine loan, a value-added deal. Suppose an experienced office building investor wants to buy a partially-vacant office building in a great location. Once again, let’s assume that the purchase price is $20 million - when the office building is still partially-vacant - and that the bank's first mortgage is $10 million. This may surprise you, but the right mezzanine lender might be willing to lend him a whopping $8 million! But isn't that 90% loan-to-value? Yes, but when the vacant space is renovated and rented – and remember that our buyer is a pro - the property may have increased to $24 million in value. Suddenly the mezzanine lender is back to 75% loan-to-value, and his rationale is obvious. Once again, this kind of loan is called a value-added deal.
The third and final use of mezzanine loans is for new construction. Suppose a developer wanted to build a 400-room hotel across the street from Disneyland. After taking a beating during the Great Recession, many large commercial construction lenders will insist on a loan-to-cost ratio of no higher than 60%. In plain English, this means that the developer has to contribute a whopping 40% of the total cost of the project. If the total cost of the project is $28 million, the developer would have to come up with 40% of $28 million or $11.2 million. That's a lot of dough. A $5.2 million mezzanine loan solves the developer's problem. The commercial construction lender would advance $16.8 million (60% LTC), the mezzanine lender would make a $5.2 million mezzanine loan (80% LTC), and the developer would "only" have to come up with $6.0 million.
There are about 60 mezzanine lenders back in the market today. You can apply to many of them by just clicking here. If you are a commercial broker (realtor) or the borrower himself, are you invited to email me, George Blackburne. In the Subject Line, please write, "I Need a Mezzanine Loan." My mobile number is 574-360-2486.
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